September 25, 2015

Reflections on the JPMorgan Episode

Note: A clarification has been added at the end of this post, after its original publication.

With the din over JPMorgan Mutual Fund’s investments in Amtek Auto somewhat fading away, I thought it would be a good time to pen my thoughts and takeaways.

First, a disclosure: I lack the competence to comment on the fundamental merits of any individual holding in a fund.  As an investor, I start with specific expectations as to the level of credit risk, concentration risk and interest rate risk in a debt fund’s portfolio. Fund manager credentials aside, I am most comfortable with funds where the levels of those risks are kept within my preferred limits.  Further, I expect an open-end fund to honour redemptions to the fullest extent possible. I look at liquidity risk as a result of conscious choices made by a fund house.

In this backdrop, therefore, I do not contest the decision of JPMorgan Mutual Fund to invest in the bonds of Amtek Auto per se.  But the extent to which this security formed a part of JPMI Short Term Income Fund does make me question both the collective wisdom within the fund house as also the diligence of investors in the scheme, and those recommending the scheme.  This security was first bought in JPMI Treasury Fund in January, this year.  Then, in February, apparently two-thirds of this investment was transferred to JPMI Short Term Income Fund, and it stood at 14% of the portfolio at the end of that month.  In fact, with this inclusion, the top 2 holdings of this fund accounted for over 25% of the portfolio value. A month later, the share of Amtek Auto had risen to over 18% of the portfolio, and the top 2 holdings now accounted for 34% of the portfolio. 

As I see it, the fund house was playing with fire.  Did the fund house truly understand the possible consequences of the risks they were taking?  If, for any reason, even one of these holdings were to become a NPA, were they clear on the impact that this would have on the NAV, on their ability to honour redemptions, and, in effect, on their credibility as a fund house?  Did they have a Plan B or were they simply acting recklessly? Irrespective, I find it difficult to sympathize with DIY investors who stayed put in the fund.  I believe that anyone who took more than just a cursory glance at the portfolio, at the very least, would have had reason to investigate further.

But what of the fund house’s decision to restrict redemptions in the aftermath of the downgrade?  The fund house claims that doing so was “in the general interest of the unit holders.”  There are also a few industry insiders whom I spoke to, who suggested that such a restriction would prevent a “run,” as they put it, on the fund.  While I wouldn’t want to speculate on what may have happened, I recognize the possibility of what they suggest.  I also understand the complexity of the situation and the absence of a perfect solution.  But I can’t help thinking that had the fund house not taken on the levels of concentration risk that it had, it wouldn’t have had to take such a step.  It was an action that one could argue was doomed, at some point or another.  It could have well been the case that seeing the huge concentration risk, investors may have attempted to leave the fund in droves, months ago.

Through all of this, though, there seeps an uncomfortable question: how much did the illiquidity of the remaining part of the portfolio contribute to the decision to restrict redemptions? If the last half-yearly portfolio disclosure is any indication, 86% of the portfolio of JPMI Short Term Income Fund was in illiquid securities.  I don’t have any evidence yet to question their valuations, but even if guidelines were adhered to, with the NAV calculations making adjustments for illiquidity, I am not sure if the NAV can really reflect the true realizable value of the underlying investments, as SEBI Regulations require it to.  Since this is something that could apply to bond funds across fund houses, this episode should give the industry something to think about.  For instance, credit lines notwithstanding, should such funds be available in an open-end structure?  If yes, then what other precautions can be taken?  To me, probably the single most sacred right of an investor in an open-end fund is to be able to redeem his/her investments at fair value, and at will.  Restricted redemptions are a violation of the trust that investors put into the open-end structure.  

Finally, I’d like to close this post with an observation, offered without comment.

It pertains to an entity which had JPMI Short Term Income Fund as one of their recommended funds.  In an explanation of their methodology some time ago, they had said that their recommendations were based on a mix of quantitative and qualitative parameters.  In their words, “we run our qualitative checks such as a study of portfolio strategies, how fund managers manage the schemes, pedigree and performance in rising and falling markets to be able to cull out a list of schemes that we feel are best suited to perform hereon.”  In a review of their list in July 2015, they continued to include this scheme.  In the aftermath of the Amtek Auto downgrade, the scheme was no longer recommended.  This is an extract of what they had to say: “At the time of its inclusion, this is what (the fund manager) had told us: “The fund caters to the more risk-averse investor, who looks for a sort of assured return. The attempt is to graduate the fixed maturity plan type of investor, but also protect her downside risk.” For a fund that aimed to protect downside risk, it has ended doing just the opposite. We retained the fund in our July 2015 audit as the said debt was due for maturity very soon and there was no change in the credit rating. Clearly this is a fund that has gone off the mandate.”

Clarification (added on September 27, 2015): The reference to the last half-yearly portfolio disclosure was based on the fact that this is the most reliable source for quickly knowing the extent of illiquid securities in a scheme’s portfolio.  A subsequent look at the disclosed portfolio of JPMI Short Term Income Fund as on August 31, 2015 showed that 67% of the portfolio was in “CBLO/ Repo” which would imply that to this extent, the portfolio was liquid.  Thus, the illiquidity of the portfolio may not have been a significant factor behind the continued restrictions on redemptions.  On the other hand, one could say that the implied level of liquidity makes the decision to restrict redemptions look more questionable.  Probably a clearer picture will emerge with the disclosure of the portfolio at the end of this month.  Nonetheless, the high levels of illiquidity in bond funds across fund houses should, as mentioned in the post, give the industry something to think about.

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